Introduction To Bear Put Spreads
A bear put spread is an options strategy that projects moderately bearish conditions on the price of the underlying security. It involves buying an in the money put option and selling and out of the money put option. Both options have different exercise prices. The long put has a higher exercise price than the short put. Also, both options have the same expiration date and are derived from the same underlying security.
The rationale as to why the put option with a lower exercise price is shorted is to reduce the cost of entering the trade. The shorted OTM put allows the trader to collect some premium which offsets the premium paid on the long put. But since the long put is in the money and the short put is out of the money, the long put has a higher option premium than the short put. Hence, creating the spread will result in a debit to a trader’s trading account. This is commonly known as a debit spread.
For an option trader to profit from a bear put spread, the trader must select from a combination of options that will make the risk and reward ratio favorable. A trader should thus limit the net debit paid and require a wide difference in the exercise prices of the options used. The difference in the exercise prices of the options used less the net debit and the brokerage commissions results in the maximum potential profit earned.
Considerations to make when placing a bear put spread(debit spread)
- Some option traders insist that the time to expiry of the options used to construct the bear put spread must have a duration that is suited to allow the price of the underlying security to move into a profitable position. For example, if a trader predicts a price move downwards of $4 within 2 months, he may use options with at least 3 months to expiry to avoid the drastic loss in time value over the last 45 days of the options’ life. Some traders insist on using options with at least 90 days to expiration when making trades in debit spreads. A bear put spread is a form of a debit spread.
- An options trader who uses a bear put spread has to limit the debit paid to carry out the trade. The lower the costs, the better the profit percentage.
- Since bear put spreads involve options of different strike prices, some traders insists on a wide difference in the strike prices used to allow for a greater maximum profit potential.
- Option traders also require the breakeven point to be within the trading range of the underlying security. As such, traders can forecast when the trade moves into profitable territory.
Note: The words “strike price” is synonymous with “exercise price”.
Step 1 : Perform economic, fundamental and technical analysis
Before an options trader executes a bear put spread, he should perform economic analysis, fundamental analysis and technical analysis. This will help the trader to determine the direction of the markets and the underlying security. For example, in a period of rising interest rates, property development/home builder companies will suffer from a slowdown in general. This is an example of economic analysis. The trader should also perform fundamental analysis to determine the valuation of the company or the underlying security. The valuation is a function of growth in earnings, free cash flow, increase in dividends, growth in sales revenue and more. Last but not least, the trader should perform technical analysis to determine optimal entry and exit points. Some chart patterns that the trader should look out for are:
Step 2 : Outlook – Moderately Bearish
The trader that executes a bear put spread is moderately bearish on the underlying security, that is, he projects that the price of the underlying security will decline moderately. Hence, it would make more sense to attempt the reduce the cost of entering the trade. If he was extremely bearish on the underlying security, he should initiate long puts instead.
Step 3 :Study the option chain
Next, study the options chain. Find options with appropriate strike prices to construct the bear put spread. Also, investigate implied volatility to ensure that implied volatility is low. Bear put spreads are best executed when implied volatility is low.
Read : Learn to read and understand options chain
Step 4 : Breakeven Analysis
The breakeven price point is the difference between the exercise price of the long put and the net premiums paid to the broker
Step 5: Understand Your Profit Zones
After calculating the breakeven point, the trader is able to understand where the profit zone lies. The trade is profitable for prices below the breakeven point.
Step 6 : Limited potential loss
The bear put spread is a moderately bearish options strategy. Hence, if the price of the underlying security goes above and beyond the exercise price of the long put, the trader experiences a loss. As a rule, as long as the price of the underlying security is greater or equal to the exercise price of the long put, a loss will result.
Step 7 : Loss calculation
As stated above, when the price of the underlying security is equal to or exceeds the exercise price of the long put, a loss will result. This maximum loss can be calculated as:
Net premiums paid to establish the bear put spread – commissions paid to the broker
Hence, as you can see here, the potential loss is limited and this can happen of the price of the underlying security goes up instead.
Step 8 : Limited potential profit
With a bear put spread, the profit that a trader can gain is limited. This is due to the intricacies of option pricing. Consider an example where the price of the underlying security breaks below the exercise price of the short call. Both options, the short and the long, will be in the money. The trader will gain on one leg and lose on another leg in such a way that the maximum profit attainable is the difference between the exercise prices of the 2 options less than initial debit paid to enter the trade.
Step 9 : Profit calculation
The maximum profit can be calculated as:
Difference between the exercise price of the options – net debit(premiums) paid to establish the bear put spread – commissions paid to the broker
Do note that the maximum profit is attained when the price of the underlying security is less than or equal to the exercise price of the short put.
Step 10 : Calculate Risk & Reward Ratio
Calculate the risk and reward ratio. Find out the ratio of risk over reward, or rather, how much of potential reward is attainable for every $1 of risk taken. This gives the trader a perspective on whether the trade is attractive when compared to other trades. These other trades should be recorded in his diary where he can make a comparison or analysis of his trades over time.
Read more : Understanding Risk/Reward Ratio For Option Traders
Step 11 : Executing a bear put spread
Sell 1 out of the money put and buy 1 in the money put. The ratio of ITM puts to OTM puts is 1:1. Both options are derived from the same underlying security and have the same expiration date.
Step 12 : Exiting a bear put spread
- If the price of the underlying security falls below the short strike price, the short put is assigned. If it is exercised by the buyer of the option, the option trader who executed the bear put spread has the obligation to buy the underlying security from the option holder at the lower strike price. The trader then exercises the long put and sell the underlying security at the higher strike price. By doing so, he earns the maximum profit.
- If the price of the underlying security falls below the breakeven point but still trades above the short strike price,the option trader can close the trade by buying to close the short put and selling to close the long put. A profit or loss may result depending on the price of the underlying security and the time remaining to expiry.
- If the price of the underlying security trades at a price above the breakeven point but below the long strike price, the trader can close the trade by buying to close the long put and selling to close the short put. If the long put is closed, the short put should also be closed as a single short put position is a naked position.
- If the price of the underlying security trades at a price above the long strike price and the options expire worthless, a maximum loss will result. Hence, an options trader should consider closing the trade as the options become out-of-the-money. This makes the most sense if there are no anticipated price moves to the downside and there is still time value in the option. If expiry is nearing, the option trader can choose to sell the long put to extract any remaining premium left in the option.
Step 13 : Record Trade In Diary
After exiting the bear put spread, as mentioned above, the trader should record the trade in a diary for the purposes of analysis. This will help him to become a better trader over time as he strives to improve on his personal trading algorithm.
Example of a bear put spread
ABC Corp is trading at a price of $48. A trader is moderately bearish on ABC, projecting that its price will decline moderately, but not significantly. He establishes a bear put spread by buying 1 ITM December 50 put and selling 1 OTM December 45 put. $3 is paid for the December 50 put and $1 is collected for the December 45 put. Hence, the trade is a net debit trade. That debit is :
($3 – $1) x 100 = $200
If the price of ABC trades downwards to $44 on the expiration date of the options, the long put will have an intrinsic value of $6 and the short put will have an intrinsic value of $1. If the trade is closed out, a profit of $6 – $3 = $3 is gained on the long put and a loss of $1 – $1 = 0 is incurred(there are no losses on the short put). Hence the total profit gained is : $3 x 100 = $300
This can also be calculated by taking the difference of the exercise prices less the net premiums paid to establish the trade. ( ($50 -$45) – $2) ) x 100 = $300
Hence, $300 is the maximum profit attainable in this example of a bear put spread and this only occurs when the price of the underlying security is equal to or less than the exercise price of the short put.
If the price of ABC trades at $51, the options will both expire in the money.
|Option||Initial value||End value||Gain/loss|
|December 50 put||$3||0||Loss of $3|
|December 45 put||$1||0||Gain of $1|
As you can see from the table above, the long December 50 put incurs a loss of $3 as it expires worthless and the short December 45 put results in a profit of $1. A net loss of $3 – $1 = $2 results. Hence, the total loss when the trading price of ABC is $51 is:
$2 x 100 = $200
This is also the net debit and/or the net premiums paid to establish the trade. Case in point, when the price of the underlying security is greater than or equal to the higher strike put, a maximum loss results.
Bear put spread vs Bear call spread
The bear put spread and the bear call spread are bearish option strategies. The difference is that the former uses puts which results in a net debit while the latter uses calls which results in a credit. Hence a bear call spread is a net credit trade.
Bear put spread vs long put
|Bear Put Spread||Long Put|
|Moderately bearish||Extremely bearish|
|Less premiums paid||Greater premiums paid|
While executing the spread reduces the cost of entering the trade as compared to just buying an ITM put, the spread however, limits the potential profit of the trade.
Read : Execute A Long put: Profit from price movements to the downside